Greenblatt and “The Little Book”
10/03/2014 10:00 am EST
John Reese specializes in developing model portfolios based on the long-term strategies of many of the stock market's most ‘legendary’ investors. Here, the editor of Validea explains the strategy of Joel Greenblatt that is based on a simple but effective two-step screening process.
Steven Halpern: Our guest today is investment expert John Reese, editor of Validea. How are you doing today, John?
John Reese: Great, thank you, Steven.
Steven Halpern: Now, your newsletter specializes in following the investment strategy of many of the market’s most notable investors. Could you give us a brief overview of this investment approach?
John Reese: Sure. Instead of inventing my own investing strategy, I identified legendary investors in the American stock market over the last 100 years who published—in a book or other academic working paper—exactly how they went about picking stocks.
And then I went about computerizing their exact steps and methodology so that I now have several computer programs implementing those guru strategies as they stated that they performed them.
Steven Halpern: Now, in the latest issue, you provide an in-depth look at Joel Greenblatt, a market guru whose strategy showed that, while investing is a difficult endeavor, it doesn’t necessarily have to be complicated. Could you expand on that?
John Reese: Sure. It’s very interesting but most of the gurus have many steps and use many variables in evaluating companies. Joel Greenblatt just uses two, which is extraordinarily simple.
Steven Halpern: Now, you referred to that as Greenblatt’s Magic Formula.
John Reese: Yes. He called it the Magic Formula. He wrote a book, it was a 2005 best seller called The Little Book That Beats the Market.
He uses two particular techniques and, by the way, this formula produced a return of over 30% per year from 1988 through 2004, which was double the S&P over that period of time.
What he did is he simply ranked all stocks by return on capital, with the best being #1, the second best being #2, etc. Then, second, he ranked them in the same way by earnings yield.
He then added up the two rankings and he invested in stocks with the lowest combined numeral ranking.
Steven Halpern: Now, you emphasize in your newsletter that this strategy is based on long-term performance and, in fact, there may be big ups and downs along the way. Could you explain that?
John Reese: Yes. It’s very important to understand that strategies can be risky in the short run and that is they can have underperforming years, like Greenblatt underperformed the markets in the strategy in years 2011 and 2012 but that performance is often times more than made up for over the long-term.
And in the years like 2009 and 2013, the model return was two or even three times the market, so the point here is that you want to understand that these types of focus value or quality models can be risky and it takes a lot of emotional discipline to stick with this approach but you put the odds in your favor if you do that.
You need to be prepared for periods of market underperformance—mentally prepared—and to live with it, knowing that over, particularly, a three to five year period would be a reasonable timeline for an investor, you are highly likely to substantially outperform the market over that period of time.
Steven Halpern: Now, as you alluded to earlier, you follow a variety of legendary investors and—on top of that—you use a screening system to develop portfolios based on these strategies. Perhaps you would be kind enough to highlight some of the stocks that currently pass your Greenblatt screening process and are described in that portfolio.
John Reese: Yes. Some of the stocks that have passed include AOL (AOL) and Time Warner (TWX), also GameStop Corporation (GME), Sturm Ruger (RGR), the gun company, is also passing, and Ebix (EBIX), an insurance software firm, is also passing the Greenblatt strategy at this period of time.
Steven Halpern: Now, again, when you compile that portfolio, you will update that on an ongoing basis so those would change over time.
John Reese: That is absolutely correct.
Steven Halpern: Well, we really appreciate you taking the time today. Thank you for joining us.
John Reese: Steve, thank you very much for having me.